After the Blowup

Laissez-faire economists do some soul-searching—and finger-pointing.

Richard A. Posner has shocked the Chicago School by joining the Keynesian revival.Credit FINN GRAFF

Some visitors to the Everett M. Dirksen United States Courthouse, in downtown Chicago, come in search of justice, others leniency. I went looking for apostasy. After passing security and riding the elevator to the twenty-seventh floor, I was shown into the chambers of Judge Richard A. Posner, the famously prolific jurist, law professor, author, and, lately, blogger, who for decades has been a leading figure in the conservative Chicago School of economics. Arranging his thin frame on a leather sofa that afforded him a gull’s-eye view of Lake Michigan, Posner held forth on the global economic slump that began in 2007, and the failure of many economists to foresee it. In a soft voice, he said, “I think the challenge is to the economics profession as a whole, but to Chicago most of all.”

A lawyer by training, Posner is also one of the country’s most influential economics writers. In his 1973 treatise “Economic Analysis of Law,” he applied the maxims of free-market economics to the courtroom, arguing that enforcing economic efficiency ought to be a primary goal of judges. Posner, who was then a young professor at the University of Chicago Law School, helped create the law-and-economics movement, which has populated many of America’s courts with judges of similar mind. In 1981, Ronald Reagan nominated him to the Seventh Circuit Court of Appeals, and since then he has written more than two dozen books, including one defending the 2000 Supreme Court decision that gave George W. Bush the Presidency.

Earlier this year, Posner published “A Failure of Capitalism,” in which he argues that lax monetary policy and deregulation helped bring on the current slump. “We are learning from it that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails,” Posner writes. “The movement to deregulate the financial industry went too far by exaggerating the resilience—the self-healing powers—of laissez-faire capitalism.” Posner also accuses professional economists, including some of his Chicago colleagues, of being “asleep at the switch.” In September, he came out as a Keynesian; in a long piece in The New Republic, he hailed “The General Theory of Employment, Interest, and Money,” which John Maynard Keynes published in 1936, as a “masterpiece,” saying that “despite its antiquity, it is the best guide we have to the crisis.”

As acts of betrayal go, this was roughly akin to Johnny Damon’s shaving off his beard, forsaking the Red Sox Nation, and joining the Yankees. Ever since Milton Friedman, George Stigler, and others founded the Chicago School, in the nineteen-forties and fifties, one of its goals has been to displace Keynesianism, and it had largely succeeded. For three decades after the Second World War, economics was dominated by Keynesian ideas about how the government should use monetary and fiscal policy to prevent slumps. Since 1974, however, more than a dozen scholars associated with the U. of C. have been awarded the Nobel Memorial Prize in Economic Sciences; in the areas of regulation, trade, anti-trust law, taxes, interest rates, and welfare, Chicago thinking greatly influenced policymaking in the United States and many other parts of the world. Keynes appeared to have been consigned to history.

But in the year after the crash Keynes’s name appeared to be everywhere; several books were published about him, and policymakers again embraced his ideas. Until the banking crisis erupted, Posner hadn’t bothered to investigate “The General Theory.” When he picked it up, he was greatly impressed by the economic insights and practical detail it contained. “Even though it is kind of loose—it doesn’t dot all the ‘i’s and cross all the ‘t’s,” Keynesian economics “seems to have more of a grasp of what is going on in the economy,” Posner said to me. Much of modern economics, by contrast, is “on the one hand, very mathematical, and, on the other hand, very . . . credulous about the self-regulating power of markets. That combination is dangerous.”

In “A Failure of Capitalism,” Posner singles out several economists, including Robert Lucas, one of Friedman’s most eminent successors, and John Cochrane, another prominent Chicago economist, for failing to appreciate the magnitude of the subprime crisis. During our conversation, Posner questioned the entire methodology that Lucas and his colleagues pioneered. Its basic notions were the efficient-markets hypothesis, which says that the prices of stocks and other financial assets accurately reflect all the available information about economic fundamentals, and the rational-expectations theory, which posits that individuals and firms are hyper-intelligent decision-makers who have a correct model of the economy in their heads. In rational-expectations theory, the economy is represented in very simplified and spare fashion. Many models, including some relied on by the Fed and other central banks, don’t even feature banks or other financial intermediaries. In Posner’s view, older, less dogmatic theories better explained how the problems in the financial sector dragged down the rest of the economy. “Of course, you have to know a lot about banking, and that was not the case with economists,” he said. “Odd, in a way, because macroeconomists and finance theorists have always been interested in banking, but I don’t think they really understood a lot about it.”

Although Posner was unfailingly polite, I detected an edge of anger in his comments about the economics profession and its embrace of such patently unrealistic theories. I asked what he thought economists had learned from the past two years. “Well, one possibility is that they have learned nothing,” he replied slowly. “Because—how should I put it—because market correctives work very slowly in dealing with academic markets. Professors have tenure. They have lots of graduate students in the pipeline who need to get their Ph.D.s. They have techniques that they know and are comfortable with. It takes a great deal to drive them out of their accustomed way of doing business.”

After leaving Posner’s office, I drove south to the University of Chicago’s Hyde Park campus, which for more than half a century has been a thriving hub of conservative thought and disputation, housing thinkers as diverse as Leo Strauss and acolytes in political philosophy, Albert Wohlstetter and his fellow Cold Warriors in nuclear strategy, and Posner, Richard Epstein, and others in law. The archetypal Chicago intellectual—embodied by Ravelstein, the chain-smoking professor of political philosophy who appears in Saul Bellow’s 2000 novel of the same name—has combined an interest in big ideas with urgent engagement in current affairs. Last fall, as the financial crisis intensified, many Chicago economists halted their own research to concentrate on the moment. “Everybody here was blindsided by the magnitude of what happened,” James Heckman, whose work on labor economics and statistics won him a share of the 2000 Nobel Prize, told me. “But it wasn’t just here. The entire profession was blindsided.” Conferences were organized, seminars were held, and faculty lunchrooms were full of vigorous debate. One panel session at which half a dozen prominent Chicago economists discussed “The Future of Markets” drew more than a thousand people to a Sheraton downtown. “Everybody got involved,” Eugene Fama, a veteran finance specialist at the university’s Booth School of Business, said. “Everybody’s got a cure. I don’t trust any of their prescriptions.”

In the course of a few days, I talked to economists from various branches of the subject. The over-all reaction I encountered put me in mind of what happened to cosmology after the astronomer Edwin Hubble, in 1929, discovered that the universe was expanding, and was much larger than scientists had believed. The profession fell into turmoil. Some physicists stuck to the existing theories, which posited a stable universe. Others, Albert Einstein included, tried to adapt the old models to Hubble’s data. Still others attempted to come up with a new account of how the galaxies formed; it was this effort that ultimately produced the theory of the big bang.

Fama, whom I interviewed in his office at the Booth School, was firmly in the denial camp. A short, wiry man of seventy, with cropped hair and wearing a short-sleeved flowery shirt, he looked more like a retired marine in Miami Beach than like one of the founders of modern finance. Beginning in the nineteen-sixties and seventies, Fama, who holds the title of Robert R. McCormick Distinguished Service Professor of Finance, propounded the efficient-markets hypothesis, which underpinned the deregulation of the banking system championed by Alan Greenspan and others. I asked him how this theory had fared in the recent crisis, which many, myself included, have described as an example of gross inefficiency. Fama was unruffled. “I think it did quite well in this episode,” he said, traces of his native Boston audible in his voice. “Stock prices typically decline prior to a recession and in a state of recession. This was a particularly severe recession. Prices started to decline in advance of when people recognized that it was a recession and then continued to decline. That was exactly what you would expect if markets are efficient.”

The emphasis that Fama placed on the stock market surprised me. Surely, I said, we had experienced a giant credit bubble, which eventually had burst. “I don’t know what a credit bubble means,” Fama replied, his eyes twinkling. “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.” Fama wasn’t kidding. He became so tired of seeing the word “bubble” in The Economist that he didn’t renew his subscription. “People have become entirely sloppy,” he went on. “People have jumped on the bandwagon of blaming financial markets. I can tell a story very easily in which the financial markets were a casualty of the recession, not a cause of it.”

The crux of Fama’s argument was that the economic slowdown predated the collapse of the mortgage market, in 2007. As job and income growth slowed, he said, some homeowners couldn’t make their monthly payments, especially the subprime borrowers who had taken out the riskiest mortgages. With delinquencies and foreclosures rising, banks and other financial institutions that had invested heavily in subprime-mortgage bonds suffered big losses, which prompted them to cut back their lending to others. “As a consequence, we had a so-called credit crisis,” Fama said. “It wasn’t really a credit crisis: it was an economic crisis.”

Fama’s story was logically consistent, but it appeared to contain a big gap. If the mortgage blowup didn’t cause the recession, what did? When I raised this question, Fama laughed. “That’s where economics has always broken down,” he said. “We don’t know what causes recessions. Now, I’m not a macroeconomist, and I don’t feel badly about that.” He cackled again. “We’ve never known. Debates go on to this day about what caused the Great Depression.”

A theory of the economic downturn that relies on inexplicable gyrations in the economy didn’t sound like a great advance, but Fama seemed content with it. He insisted that the real culprit in the mortgage mess was the federal government, which instructed Fannie Mae and Freddie Mac to buy subprime mortgages and mortgage securities. “That was a government failure; that was not a failure of the market,” Fama said. According to figures quoted in the Washington Post, Fannie and Freddie’s purchases accounted for less than a third of the subprime market at the height of the boom. When I pointed out that private investors bought most of the subprime securities issued, and the two big government-backed mortgage companies considerably less, Fama said simply, “How much does it take?”

In addition to accusing the government of causing the subprime problem, Fama argues that it botched its handling of last fall’s financial crisis. Rather than bailing out A.I.G., Citigroup, and other firms, Fama says, the Treasury Department and the Federal Reserve should have allowed them to go bankrupt. “Let them all fail,” he said, with another laugh. “We let Lehman fail. We let Washington Mutual fail. These were big financial institutions. Some we didn’t let fail. To me, it looks like there was not a lot of rhyme or reason to it.” He conceded that the entire financial system might well have shut down for a period, but he expressed confidence that investors and healthy banks would have stepped in to buy the good assets of the collapsed firms, and that, within a week or two, the system would have been operating again. “It pretty much stopped for a week or two, anyway,” he said. “The credit markets stopped for more than a week or two.”

Fama was no less genial on the subject of Posner. “He’s not an economist,” he said. “He’s an expert on law and economics. We are talking macroeconomics and finance.” Even when I brought up Paul Krugman, who had criticized efficient-markets thinking in a recent essay in the Times Magazine, Fama’s equanimity was unshaken. “My attitude is this,” he said. “If you are getting attacked by Krugman, you must be doing something right.”

In the office next to Fama’s, I encountered another true believer, John Cochrane. During last year’s financial turmoil, Cochrane, who happens to be Fama’s son-in-law, helped to organize a petition against the Treasury Department’s seven-hundred-billion-dollar Troubled Asset Relief Program; more than forty Chicago economists signed it. “What is there about recent events that would lead you to say markets are inefficient?” he said to me. “The market crashed. To which I would say, We had the events last September in which the President gets on the television and says the financial markets are near collapse. On what planet do markets not crash after that?” Earlier this year, Cochrane wrote several articles arguing that the Obama Administration’s stimulus package lacked a theoretical basis. When I brought up Posner and the broader Keynesian revival, he insisted that Keynesian economics had been plagued for decades with logical inconsistencies, which recent events had done nothing to remove. “We threw it out for a reason,” he said. “It didn’t work in the data. When inflation came in the nineteen-seventies, that was a major failure of Keynesian economics. ”

After talking to Fama and Cochrane, I understood what Posner meant when he said that his opponents were “sticking to their guns.” (Robert Lucas refused to see me, saying in an e-mail, “I don’t want to do this.”) Elsewhere, however, I found more willingness to acknowledge errors and seek new ways forward. “There are a lot of things that people got wrong, and I got wrong, and Chicago got wrong,” Gary Becker, who won the Nobel in 1992, said when I caught up with him late one afternoon. “You take derivatives and not fully understanding how the aggregate risk of derivatives operated. Systemic risk: I don’t think we understood that, either—at Chicago or anywhere else. Maybe some of the calls for deregulation of the financial sector went a little too far, and we should have required higher capital requirements. Although that was not just Chicago. Larry Summers”—the Harvard economist, who is now President Obama’s top economic adviser—“when he was at Treasury supported deregulation.”

Becker is famous for extending economic analysis to areas such as education, crime, and family behavior—he has gone so far as to suggest that having children is driven partly by financial considerations. At the age of seventy-nine, he still teaches three graduate courses; notes were piled up on his desk, next to a twenty-inch iMac. A major cause of the crisis, he said, was that Wall Street financial engineers devised a series of new instruments that neither they nor the people who traded them fully understood. In the housing market, buyers had unrealistic expectations about future price gains, and a bubble formed. “Yeah, markets aren’t fully efficient,” Becker said, with a wave of his hand. “But the general thrust that markets are more efficient than any alternative—that aspect I don’t think is going to be changed.” He added, “I don’t see China, or Brazil, or a lot of other developing countries making any radical changes in their movements toward the market, and I think for good reason.”

Unlike some of his colleagues, Becker believes that the federal government did a pretty good job of reacting to the financial crisis, both in extending trillions of dollars to frozen credit markets through the Federal Reserve and in bailing out the big banks. “I don’t accept the view that in this crisis we should just have let everything fall where it may,” he said. “Yeah, the economy would have picked itself up, but it would have been a much more severe recession.”

Becker writes a popular economics blog with Posner, where the two of them have debated Posner’s late-life conversion. When I brought it up, Becker said that Posner wasn’t the only apostate; the revival of interventionism had led him to believe that ninety per cent of economists had been Keynesians all along but had been too afraid to admit it. Still, he conceded, Posner and others had raised fair critiques of Chicago economics: “Some of the models that were being promoted in macro didn’t turn out to be that useful in helping us to understand what to do to combat a major recessionary event.”

That sounded like a criticism of Lucas, whose office was just down the hall. In Lucas’s rational-expectations theory, the economy is self-regulating. If in one period a shock—a big rise in the price of oil, for instance—causes output to fall and unemployment to rise, in the next period the economy automatically adjusts back to a state of full employment. The explanation for long stretches of mass unemployment, such as the Great Depression, is that workers refuse to accept lower-paying jobs and prefer to remain out of work. In such a world, most forms of government intervention are inherently futile. When I asked Becker about Lucas, he said that his colleague had made “a major contribution” to economic theory (he won the economics Nobel in 1995), but suggested that Lucas’s followers might have erred. “Some people did rule out the whole financial sector, seeing money as being unimportant,” he said. “I think that stuff just turned out to be wrong.” James Heckman, one of five current faculty members to win the economics Nobel, was more explicit in his criticism of Lucas’s methods, and he told me that Friedman, who died in 2006, had also been skeptical of them. During the seventies, Heckman recalled, he and Friedman took part in the oral examination of a Ph.D. candidate whose thesis employed rational-expectations techniques, which were then sweeping the field. In the course of the examination, Friedman turned to Heckman and said, “Look, I think it’s a good idea, but these guys have taken it way too far.”

By Chicago standards, Heckman is a centrist; his research on preschool education and other issues has influenced both Democrats and Republicans, and during the 2008 Presidential election, the Obama campaign asked him to assess its education proposals. But, like most of his colleagues, he places a great deal of emphasis on incentives and has expressed skepticism about many government programs. “I think the underlying ideas of the Chicago School are still very powerful,” he said. “The base of the rocket is still intact. It is what I see as the booster stage—the rational-expectations hypothesis and vulgar versions of the efficient-markets hypothesis—that has run into trouble. I think what happened is that people got too far away from the data, and confronting theories with data. That part of the Chicago tradition was neglected.”

If the economic equivalent of a big-bang theory is to emerge, it will almost certainly come from scholars much less invested in the old doctrines than Fama and Lucas. Ambitious tenure-track professors at Chicago, like their rivals at other schools, are busy trying to incorporate into their theorizing previously neglected facets of reality, such as banking failures, financial-market bubbles, and credit crunches. This research presents a formidable challenge. A big reason that rational-expectations models proved so alluring to economists was their tractability: with some clever math and a computer, they could be “solved out” to generate explicit solutions for important economic variables, such as unemployment and inflation. Adding institutional detail complicates things greatly; so does allowing for psychological factors, such as overconfidence. “People say economics needs to incorporate the insights of psychology,” Cochrane said to me. “Great, thanks! I’ve heard that from Bob Shiller”—a well-known Yale economist, who wrote the 2000 book “Irrational Exuberance”—“for thirty years. Do it! Let’s see a measure of the psychological state of the market. That’s hard to do.”

In the nineteen-sixties and seventies, Chicago economics was largely cut off. Other leading schools, such as Harvard and Berkeley, rarely hired Chicago graduates, and Chicago returned the favor. Today, the gap is much narrower, partly because many of Chicago’s ideas have been incorporated into mainstream thinking, and partly because it has recruited more widely. The most famous Chicago economist today is Steven Levitt, an M.I.T. Ph.D. and the co-author of “Freakonomics,” who is known for innovative empirical studies of crime, abortion, and teacher performance. Richard Thaler, one of the creators of behavioral economics, which seeks to combine the insights of psychology and the rigor of economics, moved to Chicago fifteen years ago; his office is now around the corner from Fama’s. In the old days, Fama recalled, “Chicago economics was basically under attack the world over. There was a type of bunker mentality. But now we’ve become more confident.”

Fama and Thaler may be friendly—the two occasionally play golf together—but their analysis of the financial crisis and its aftermath could hardly be more different. Fama clings to the idea of efficient markets; Thaler takes the view that in the past ten years the U.S. economy has experienced two ruinous speculative bubbles, and that policymakers ought to focus on ameliorating them. “I think we know what a bubble is,” he said. “It’s not that we can predict bubbles—if we could, we would be rich. But we can certainly have a bubble warning system.” Such a system would focus on standard valuation measures, such as price-to-earnings ratios for stocks and price-to-rent ratios for housing. If these warning signs start flashing, Thaler went on, the government should rein in speculative activity, by, for example, raising lending requirements in overheated real-estate markets. “God did not say, ‘Thou shalt be able to borrow one hundred per cent of the price of a house,’ ” he added.

To Thaler, the key causes of the financial crisis were high leverage and human frailty. Many of the home buyers who were taking out subprime-mortgage loans didn’t know what they were doing, he insisted, and Wall Street C.E.O.s failed to understand what their traders were up to. “Go down the list—A.I.G., Citigroup, Bear Stearns, Lehman. All of these companies were destroyed or devastated by a small part of the business that was hurtling forward and risking the entire firm. The people in charge were greedy or stupid, or possibly both.”

At Chicago and elsewhere, behavioral economists have elucidated many activities that appear to contradict rational-choice theories. So far, however, they haven’t converted these insights into a workable model of the economy as a whole. A useful new economics will need to integrate an awareness of human nature with extensive practical knowledge and high-level mathematical expertise. In an office a floor above Fama’s, I met with Raghuram Rajan, a forty-six-year-old Indian-born scholar who is one of the few economists who warned about the dangers of a financial crash. At a conference organized by the Fed in 2005, he said that deregulation, trading in complex financial products, and the proliferation of bonuses for traders had greatly increased the risk of a blowup. Senior Fed officials and other prominent economists dismissed his concerns. Lawrence Summers said that Rajan’s critical tone supported “a wide variety of misguided policy impulses.”

Rajan, with his colleagues Douglas Diamond and Anil Kashyap, has for years been examining potential problems in the banking sector. The work of this group didn’t attract much public attention, but it turned out to be very useful to policymakers and other economists in analyzing the credit crisis and formulating the government’s response, which Rajan supported. “Research drives thinking, and there is all sorts of research being done here,” he said. “People at the extremes get a lot of press—people who say, ‘Let’s not do anything, let’s liquidate.’ . . . There are people at Chicago who hold that view. There are others who understand that the banking system is a lot more important than, and different from, most corporations. Yes, you can close down some banks without a problem, but there are some banks that are so intertwined that you don’t have an option.”

Rajan, who worked from 2003 to 2006 as the chief economist at the International Monetary Fund, has experience with financial blowups in developing countries, where irresponsible macroeconomic policies, poor supervision, and crony capitalism—banks extending reckless loans to influential people—often distort economic behavior. “The whole point about development is that you deal with some of these problems,” Rajan said. “You don’t have populist extensions of credit. You don’t have banks going haywire.” In some ways, Rajan went on, the subprime crisis resembled earlier collapses in Southeast Asia and Latin America. “You can’t pin it all on Greenspan,” as many have done. “It is a systemic breakdown, and we need to look more broadly at why it happened.”

In a new book he is working on, entitled “Fault Lines,” Rajan argues that the initial causes of the breakdown were stagnant wages and rising inequality. With the purchasing power of many middle-class households lagging behind the cost of living, there was an urgent demand for credit. The financial industry, with encouragement from the government, responded by supplying home-equity loans, subprime mortgages, and auto loans. (Notwithstanding the government’s involvement, this is ultimately a traditional Chicago argument: in response to changing economic circumstances, the free market provided financial products that people wanted.) The side effects of unrestrained credit growth turned out to be devastating—a possibility that most economists had failed to consider. “The fault of the economics profession was not so much rational expectations, which is a convenient and useful device,” Rajan said. “It was to ignore the plumbing. Economists could afford to do that for a long time because the plumbing didn’t back up. Now that the plumbing has backed up, you find that loans aren’t really made in a pure, pristine market. Things can break down.”

Twelve months ago, it appeared that history had turned against laissez-faire economics. Even among the Chicago faithful, there was reluctant acceptance that, if politicians were unwilling to let big banks fail, stricter financial regulation was needed to prevent further taxpayer bailouts. Fama and Becker both endorsed limits on bank leverage, so that bankers are playing with more of their firm’s own money. Cochrane called for a breakup of big financial firms, such as Citigroup and Goldman Sachs, with their trading activities being separated from the banking services they provide to customers. Rajan and Kashyap, meanwhile, advocated reforms in the compensation packages of Wall Street traders and C.E.O.s.

Today, though, the political and financial environment is somewhat different. Thanks to government action on an enormous scale, the banking system has been stabilized and the U.S. economy is expanding, if at a moderate pace. Ironically, the rescue program has taken some of the heat out of the economic debate. In Chicago, as elsewhere, most economists have returned to their own research projects. “If this recession had got a lot worse, we would have seen two major things,” Becker said to me. “Much more government involvement in the economy and a lot more concentration in economics on understanding what went wrong.” Assuming that the economic recovery continues, he went on, “there will be nothing like the revolution in the role of government and in thinking that dominated the economics profession after the Great Depression.”

Becker may be right, but the impact of the financial crisis shouldn’t be underestimated, especially for Chicago-style economics. “Rational expectations and strong views of efficient markets have taken a terrific hit,” Posner pointed out to me. “Keynes is back, and behavioral finance is on the march.” Outside of Fama and his followers, it is hard to find anybody, even in Chicago, who believes that speculative bubbles aren’t a serious problem, or that the U.S. economy automatically adjusts to full employment. And even most of the diehards now support efforts to regulate Wall Street more effectively.

Posner, in a new book he is working on entitled “The Crisis of Capitalist Democracy,” reiterates his call for economists to embrace some of Keynes’s original ideas, and questions the U.S. government’s ability to pay off its vast debts without resorting to inflation. Before I left Posner’s office, he gave me a brief history lesson. By the late nineteen-eighties, with the collapse of Communism, the basic insights of the Chicago School about deregulation and incentives had been accepted worldwide, he recalled, and the bitter enmity between Chicago and its rival economics departments had faded. Eventually, many of the founders of the Chicago School died, and were replaced by more moderate figures, such as Thaler and Levitt. Now, largely as a result of misguided efforts to extend deregulation to the finance industry, we have experienced the biggest economic blowup since the nineteen-thirties. Posner, who appeared to be enjoying his new role as a heretic, paused, then said, “So probably the term ‘Chicago School’ should be retired.” ♦